Why is UK monetary policy (still) failing?

Monetary conditions in an economy are considered to be a forerunner of economic activity to come in the real or actual economy. For example a change in official short-term interest-rates is expected to have its full impact after a period of 18/24 months. However over the period of the credit crunch we have seen that the interest-rate weapon has been deployed pretty much to its maximum in the UK as base rates were cut to 0.5% as long ago as the 5th of March 2009 making a fall of 5.25% from the previous peak. So on the logic described earlier in this paragraph the effect of this has been and gone. As the UK economy has struggled you are excused for missing it!

So as the Bank of England quite quickly found that it had used its interest-rate weapon as far as it felt it could it then moved from the price of money to the quantity of money in the UK system. Today I wish to analyse the impact of these policies and examine where we stand.

Quantitative Easing

As the interest-rate revolver fired its last round in March 2009 (so far anyway) the Bank of England started a programme to increase the quantity of money in the UK system called Quantitative Easing. Here is it’s explanation of this.

The Bank of England electronically creates new money and uses it to purchase gilts from private investors such as pension funds and insurance companies.

I do not think that you could get a clearer description of an attempt to raise the money supply or the quantity of money than that! The effect of this according to the Bank of England should be this.

The purpose of the purchases was and is to inject money directly into the economy in order to boost nominal demand

They do not explicitly say this but nominal demand was supposed to lead into higher real demand in our economy giving it a boost and helping us to recover. Job done? Er not quite, as in practice a lot of the boost to nominal demand from the £375 billion of QE went into rising prices or inflation. Inflation went above its official target for CPI inflation in December 2009 and has remained there ever since and is currently running at an annual rate of 2.7% by this measure. Sadly economic growth was revealed earlier this week to be running at an annual rate of -0.1%. As you can see this is certainly not the sort of mixture implied by this statement from Paul Fisher of the Bank of England from March.

Really the effects have been quite powerful

Perhaps he forgot to say on inflation!

The Bank of England moves from narrow to broad money

In essence the main original impact of QE was on what is called narrow money as it created funds. It is true that this also increases broad money and was hoped to lead to further increases in broad money. However as this disappointed it has moved onto a plan which it hopes will increase the growth of broad money.

Funding for Lending

This is designed to directly raise the money supply by encouraging UK banks to lend via the mechanism described below.

It will do this by providing funding to banks and building societies for an extended period, at below current elevated market rates, with both the price and quantity of funding provided linked to their performance in lending to the UK non-financial sector.

So if they lend more they will get the carrot of cheaping funding and finance. You may spot that this is something of a Holy Grail too for UK economic policy as on its way to hopefully boosting bank lending it will also boost bank profits! How often will we find ourselves observing such “coincidences” over the credit crunch and its consequences? Actually I could take away the plural of coincidence because it is always the same one is it not?

Returning to the monetary system then FLS is supposed to have this consequence on the real economy.

Easier access to cheaper bank borrowing should boost spending in the economy, for example by allowing families to purchase homes, or by allowing firms to finance investment in new and productive enterprises. In turn, higher spending should create jobs and raise incomes.

Magnificent is it not? Or at least it would be if that was what was happening! So far there appears to be an issue with lending to businesses.

Adding this up

So we have monetary policy is nearly every guise here. First interest-rates were cut heavily then we saw narrow money increased via QE (with hopes for a broad money boost) and now we have the FLS for broad money. If you also feel that the depreciation of sterling of 2007/08 was tacit official policy then you would have what a card player calls a full deck.

So where do we stand?

If we move on from the hype and the promises above let us take a look at the UK monetary system from today’s data.

Bank Lending

Rather inconveniently for all the methods deployed above this continues to struggle. Net business lending on the Bank of England’s favourite definition which excludes financial corporations did rise but by only £100 million in October. On a three month basis it fell by 2.7% and on a year on year basis it fell by 2.9%.

Lending to individuals had a growth of £200 million in October and a year on year growth rate of 0.7% which represent weaker numbers than earlier in the year. If we consider the efforts described above to increase mortgage lending we are further troubled because across all categories it was £9.9 billion in October 2011 and it was £9.7 billion this October. So a fall before we allow for inflation.

Perhaps if we step back from the hype telling us about mortgage rate cuts etc. we may find a possible clue to this in the fact that according to the Bank of England’s overall measure mortgage rates are a quarter point higher than a year ago! Also new business lending is at a rate 0.4% higher!

M4 Money Supply

If we look at the money supply itself we do see signs of growth but if you look at the numbers below we also see a problem.

M4 excluding intermediate OFCs increased by £6.8 billion in October, compared to an average monthly increase of £6.9 billion in the previous six months. The three-month annualised growth rate was 5.4%.

The problem is that we have pretty much the same rate of growth as the past six months and if you review what has happened over that period you will get my point. If it is going to help then it should be doing so soon! Worryingly the rate of growth in percentage terms is in fact slipping back as September was 4.2% and October 4.1%.

So we can conclude that it looks like official policy has helped raise the money supply but so far it has failed to help bank lending. Also we need to note that money supply is rising on the Bank of England’s preferred measure and we have seen in the past how picking and choosing between measures can explode like a hand grenade on economic policy. In case you were wondering how we went from M3 (actually £M3) to M4 then as Run DMC put it.

it’s like that,

Comment

Today I have looked at the UK monetary system which if it was a tap would have been turned to pretty much full on by the various efforts of the Bank of England. However to their professed surprise, but not mine, it has failed to have the impact desired on the real economy. Rather than growth it has given us inflation.

So if we analyse the increase in the money supply that is taking place on the Bank of England’s favourite measure I feel that we return to the same question. How will it be split between economic growth and inflation?Personally I fear that much or all of it will be lost in the direction of higher inflation again. We also know that via its impact on real wages that inflation has had a depressing influence on our economy in the credit crunch era. I do not know the exact mix because it will depend on factors such as future oil and commodity prices but whilst I hope for growth I fear more inflation.

One factor we can be sure of is that official policy keeps time and time again returning to policies which will boost bank profits. I will let readers decide whether the report from the Financial Policy Committee has confirmed this today.

Our aim must be to get to a point where private investors again have confidence in banks

Personally I think that there is a conflict here as those with thinking faculties will always find their mind returning to the question, why do banks need all this support? To that question there is no good answer.

Whilst such thoughts are by their very nature subjective it is my opinion that such factors are a major reason why our economy is not recovering. We as people have learnt things and are not the same as we were before the credit crunch and to work official policy needs to change. Sadly those in charge are either unwilling or unable to figure this out.

“If you also feel that the depreciation of sterling of 2007/08 was tacit
official policy then you would have what a card player calls a full
deck.” Hi Shaun, to use your own expression hereon today, those with thinking faculties do conclude that this is and was tacit policy of the present government and BoE; indeed the principal purpose of the continued “emergency” base rate (ZIRP) and QE debasement was never intended to “stimulate” the UK economy; debasement can never stimulate any economy; it purely destroys the real wealth generating processes, as we have seen in the most extreme examples in other economies already in history. Thus all of this nonsense from the BoE and government has been only “Truth-Speak”. The sole real purpose of QE debasement has been to bail out the banks and the government who are both in reality insolvent – the banks due mainly to horrendous derivative liabilities and the government due to continued serial profligacy. That is why as you seem to have observed now the BoE and the new governor are puppets of the government. Without continued QE debasement now, as a result of their dire failure to reduce public spending in real terms, the UK government and the UK economy will collapse. If the markets do force up interest rates in January, if rating downgrades are on the horizon as feared, then the government will eventually struggle to service its debt unless it resorts to much greater QE debasement in a Zimbabwe style, and then the inevitable hyperinflation will be firmly on the horizon. What needs to be considered is what that scenario will do to the UK economy? The probability is that the UK is heading to become another “banana” economy; and we cannot in this climate even grow bananas!

http://twitter.com/silentfp Chris F

Good piece Shaun – the BoE’s policies have done everything to help the banks (who’ve promptly gambled it again), and that at the expense of every other citizen. Independent? Only of accountability to the people.

It becomes more apparent with every press conference they have. Thanks for using your own thinking faculties to keep sharing these truths with us.

*insert relevent song lyric here – I can never think of any*

forbin

hehe , thats funny

” the BoE’s policies have done everything to help the banks (who’ve promptly gambled it again)”

What do you get if you give a million pounds to a broke gambler ?

a broke gambler !

What can be done to restore confidence in the banks ?

legal reform and prosecution of those guilty in the banks

At no point so far has any politico pushed for this nore has the press

Thus I conclude they are complicit in this fraud and we are doomed as tax payers to keep paying until we are bled dry

Forbin

Governance of the people by the banks for the banks

Critic Al Rick

UK monetary policy is failing to ignite growth but I doubt general economic policy is failing its intended objective; general economic policy in the West is succeeding very well in suffocating economys in the West.

Nero fiddles whilst Rome burns.

Rods

Hi shaun,

I see in the press today the BOE thinks the banks will need to raise another £35bn. Anyone for another £100bn or 2 of QE to help the banks on their way?

You would think the way the Government acts to indirectly support the banks, that they had a direct financial stake in them. Oh err they do in two of them. So their policies are all transparent then for the good of the people!

Until the economy is rebalanced by real public spending reductions and tax cuts there will be no growth, just stagflation Real wages will continue to drop through high inflation, while people that have spare money and debts will continue to pay these down, where they are fearful for the future in terms of UK solvency, growth, unemployment and currency debasement through inflation, and once this gets a real grip, it will lead rapidly rising interest rates and a further squeeze on those with mortgages and debts.

Not a good outlook, but with the BOE and Government failing to get to grips with our economic problems, this is not going to end well.

james

Shaun,
If you need entertainment on this subjcet, read the spoof Private Eye interview with George Osborne this week. It really does capture the insanity of QE!!

DaveS

Forbin – banker bashing is popular – but what exactly did they do wrong ?

As I see it, the UK banks in particular expanded their balance sheets to lend primarily against property. They borrowed short mostly from abroad and lent long mostly against residential and commercial property.

There may have been losses from so-called casino speculation on credit derivatives e.g. RBS mainly via ABN AMRO – but wasn’t most of the problem caused by plain old property lending in a property bubble e.g. HBOS with commercial property, RBS in Ireland & USA etc, Northern Rock on UK property. Maybe i’ve forgotten the details – were there big losses directly to Lehmans ?

I thought a lot of the early problems in 2008 were caused by liquidity – wholesale and retail bank runs – inability to role over short term borrowing and then loss of confidence. But borrowing short and lending long is normal – they just did it on a much bigger scale and increasingly from abroad.

Now the massive expansion of their balance sheets to fund the property bubble – well that was irresponsible. But no-one stopped them – just the opposite. The central banks were happy, the political leaders were happy (gave them knighthoods) – in US, Clinton encouraged the banks to lend sub-prime. They just did what you would expect – they maximised their profits.

The reason everybody was happy, is that globalisation couldn’t work unless the banks provided the conduit for huge flows of debt from the surplus countries (e.g. China, Germany) to the deficit countries (e.g. UK, Greece). Economic growth for both sides relied on the debt flowing – that is why growth has stalled now .

The fault lies with the politicians & economists that led us into this crazy unbalanced & inherently unstable economic system. The bankers were big beneficiaries for sure and have been bailed out when they didn’t deserve to be. But what did we expect them to do ? – put their hands up and say “sorry folks we are making too much money here – don’t listen to the regulators, central bankers and leaders who say this is just great, no more boom/bust”.

pachadwick

Yes, I agree broadly with “Drf”. The whole ZIRP and QE is an attempt to mask insolvency via an inflation adjustment. Sustainability used to be a word championed a couple of years ago by logical and practical folk but I am afraid a conscious or planned economic reset option was “given-up” in 2008. You will have noticed that the desperate stares and circular reasoning of excuses by policy makers. The trouble is that the “half-life” of their treatments is getting shorter, QE in ever larger chunks is the inevitable conclusion of the course taken so far and the wheel ruts are now very deep. There was a chance back in 2008 that if we clung on 2,3,4 years that BRICs countries could have “pulled us out” with exporting demand but I just don’t see it now in 2012. I think 2013 will be very interesting , where is Dr Doom….? Regards Paul Chadwick BSc (Econ)

forbin

Hello DaveS,

The important point is that it was the politicians who by their actions – or inaction if you will , allowed the crdit boom.

In the end days I hope that this will be seen by the general public but I cannot see the media allow them to see this

I hope that GB gets his just come uppance – he is not the only one and I dont in general agree to be blaming one person , but…..

” But what did we expect them to do ? ”

yah you correct I would not really expect them do have done anything else .

But what to do next is the vexing issue

and printing our way out I feel is inevitiable

Forbin

Noo 2 Economics

Hi Shaun, I’ve said before and again now, the UK economy will grow in Q4 2012 and Q1 2013. M1 and M4 have been outgrowing inflation for most of 2012, that will result in economic growth this quarter and the next.

Unfortunately, inflation is once more catching up. I agree your overall point that QE is not a sustainable long term economic growth plan, but it can result in short term bursts of growth until inflation catches up again. QE is clearly here to help Government and banks reduce their respective debts by causing a stealth tax known as inflation!

Noo 2 Economics

Dave S

1.”banker bashing is popular – but what exactly did they do wrong ?” and

2. “But what did we expect them to do ? – put their hands up and say “sorry
folks we are making too much money here – don’t listen to the
regulators, central bankers and leaders who say this is just great, no
more boom/bust”.

1. The real question is why did the wholesale markets from which the banks borrowed short dry up very quickly? Because the Wholesalers suddenly realised the banks were issuing lots of sub – prime mortgages in the UK too. Not only this but the UK banks were simply taking applicants’ word at face value re their declared income and weren’t even bothering to check potential mortgagees declared earnings with the mortgagee’s employer! Minimum periods of employment requirements were scrapped too! Then there was the nonsense of lending 100% and more of the purchase price including the value of the land the property was built on. That’s what I call a high risk buccaneering approach to long term mortgage issuance. This is what the UK bankers did wrong and this is why the Wholesale markets stepped away.

2. Well, yes in a word. They were supposed to be the level headed, sober, conservative (with a little c) heads of safe, secure bastions of the financial pillars of the economy whom could be trusted. Of course we have learned differently now and are now regarded with contempt and mistrust. II doubt they will regain the trust of the population before another generation has come and gone.

http://twitter.com/notayesmansecon Shaun Richards

Hi Drf
It is interesting that Mervyn King wants another depreciation of the value of the pound. In this respect we can be clear that he is going against JM Keynes who offered the famous phrase “When the evidence changes I change my mind,what do you do Sir?”
In fact Mervyn King’s last few years as Bank Governor seems to be based on ignoring such questions…

http://twitter.com/notayesmansecon Shaun Richards

Hi Rods
Whenever there is an official estimate of what a bank or group of banks needs in terms of a bailout you can be sure that even the upper bound will only be a starting point….

http://twitter.com/notayesmansecon Shaun Richards

I will take a look thank you. Apparently there was also a show on this week where Rowan Atkinson played a banker version of Blackadder. Quite what cunning plans he would concoct as a banker i dread to think!

http://twitter.com/notayesmansecon Shaun Richards

Hi Paul
We may find out some more about one of the alternative destinations should the LDP win the Japanese elction in the middle of next month. Its leader Abe san has been repeating his 3% inflation target mantra which if enacted will have to mean QE to the max and negative interest rates (unless he becomes a late convert to rasing the sales tax)

http://twitter.com/notayesmansecon Shaun Richards

Hi Noo 2
It may be tight as to whether we see positive growth in Q4 but if we move on from quarterly numbers and look at the over all trend QE has disappointed. As I put in today’s post any gain from QE for the real economy has in the UK’s experience so far been eroded and maybe wiped out by the falls in real wages that the higher inflation path has given us.

Anonymous

what did the banks do wrong ? liars loans and120% LTV mortgages.

the biggest problem with bank bailouts is the moral hazard of rewarding failure ….

Rods

Hi Shaun,

UK inflation certainly is high at the moment, what started out at £35bn the banks need to raise this morning has changed with losses to a need of at least £60bn tonight! And tomorrows figure will be…

Time to invest in some wheel barrow makers shares maybe.

James

As an ex-investment banker myself, I would say that the thing that banks did wrong was to allow traders to take over the balance sheet without ever understanding what they were doing. I was in the city (on the advisory side) when big bang happened and you suddenly had people who had lent money as a career buying stockbrokers (not too serious because they didnt trade in a proproetary fashion) and jobbers (disaster, as they did).
I can assure you that the top people at my bank, Kleinwort Benson, would not have known what a trade was if it hit them in the face.
You then had the explosion in derivatives. The idea that the risk of derivatives was understood was just laughable but the profits (unreal, generally) turned even the sanest of heads. If you look at the history of Barings going bust, Nick Leeson apparently made so much money in the Far East that he constantly needed extra funding from the UK until he had the whole capital base of Barings sent to him. Not one director at the bank asked why, if it was so profitable, he needed extra cash.
But even derivatives trading needs a capital base. You can either create one by raising money for the purpose or, rather more conveniently, you can use an existing one known as a clearing bank. This has the added advantage that you can collect your rather agreeable bonuses and, whatever mess you make, the bank does not go bust.
I am frankly amazed that we are not stringing bankers up on lampposts. I know, as an ex-insider, exactly what they have done. They have uttrerly trashed our economy while collecting obscene rewards and still do not get it.

Drf

Hi James: an excellent comment which essentially summarizes the causes very well; I also worked in Investment Banking for a significant number of years in the City and 4 other key financial capitals abroad, and can support all that you write here. Many people are just not aware of the potential derivative liabilities which the major banks still have, and which to a great extent they have hidden (as skeletons in their cupboards) from the governments which bailed them out in their last insolvency before the receivers were called in. These still run into trillions of $ and total much more than the complete global GDP. If you think what will occur if and when many of these become payment liabilities due for redemption instead of revenue stream generators the mind boggles! It is of course the large leverage which generates the significant profits, but also the horrendous liabilities if the risk goes wrong. Only yesterday even Mervyn King pronounced that the main 4 banks in the UK would need something like 38 billion of additional capital to cover the likely liabilities and he of course is one of the unaware “top people” to whom you refer, who clearly do not properly understand these things. The amount he stated is a severe under-estimate in my opinion.

Shaun Richards is an independent economist who studied originally at the LSE. His speciality is monetary economics and he uses it to analyse current economic trends. He started his career in the City of London in 1985 and brings his trading experience in bond, currency and derivative markets to his analysis of current economic events. Follow him on twitter @notayesmansecon.